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By | October 2012
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Making investment decisions is an integral part of financial management. The importance of reaching a right investment decision comes from that once an improper investment decision was made, it will be very difficult for the business to withdraw its invested resources without significant losses. This makes it a mandate for investment decisions such as purchasing a new machine, or investing in a new facility to be well assessed and evaluated. The most common assessment methods for investment decisions in today's organizations are: Accounting Rate of Return (ARR), Payback Period (PP), Net Present Value (NPP), and Internal rate of Return (IRR). Accounting Rate of Return (ARR): In this method the average profit of the organization after deducting the taxes and depreciation is expressed as a percentage of the average investment made in the project over its period of existence(Atrill & McLaney, 2011). In case of appraising a project, the result of this percentage is compared to a minimum percentage for the particular business, and if it exceeds this minimum percentage then the project is acceptable, and for mutually exclusive projects, then the project with highest ARR will be chosen. From this description we can see that absolute value of ARR means nothing in itself, and it must be compared with other ARR results in order to be used to support decisions. Also it ignores the depreciation of the value of money with time which is called time value of money (Anon, n. d.) This is a major flaw with this method especially for big investments that takes longer times. Payback Period (PP): This method represents the period of time it takes the business to generate cash that equals to the initial investment. For an investment to be acceptable it should provide a PP that is less than the set maximum pp period for the business, for more than one project, the project with shorter pp should be considered. Disadvantages of this method is that it only considers cash flow until...
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